“It's a great topic you have chosen and I fully support your intention on preventing the next crash. But I feel that the world is controlled by a bunch of morons that either just want as much money and power as possible for themselves – or are afraid to question the status quo. I think that the solution lies in educating the people of our planet on how it works so that we together can create a new system where the power is more distributed (as opposed to concentrated) – I am certain such a system is much less likely to crash. With a currency that means something and cannot just be diluted by a government to boost the economy's statistics and please the markets and thereby the few in monetary power. I think you get my point – good luck with the book! Use your famous names and great intellects [and good looks, ed.] for the future good of humanity :)”

“How to prevent economic crises?, how to have a long-term stable global economy?, are we complicating a simple thing (economy and its study)?, what should an individual do to shield from inconsistencies of the economy?”

“Qualitative analysis also needs to be included.”

—Answers to the survey question: “What topics should definitely feature in the book?” at wilmott.com

Human beings learn, or are supposed to learn, from past mistakes. Building codes, fire codes, engineering codes, and safety codes of all sorts carry within them the memory of past disasters. Boiler explosions were common in the 19th century, until their designers started to follow pressure codes. In finance today, even insurance companies blow up, which takes some of the security out of having insurance. So how can we reform the rules of financial markets to make them more boringly reliable, and is that even possible? This final section proposes some principles that a financial engineering code should include or reflect.

“Keep it simple, stupid – KISS – is our constant reminder.” Thus spoke Lockheed engineer Kelly Johnson, who long served as the firm's Head of Advanced Development Projects.¹ His projects – which included what was in 1964 the world's fastest and highest-flying aircraft, the SR-71 Blackbird – pushed the limit of performance; but he knew that an overly complicated mechanism was both more likely to go wrong and more difficult to repair (especially if you were in the middle of a battle).

The world financial system, unfortunately, does not appear to have been designed with the same principle in mind. Instead of being simple and clear, it is complicated and opaque. Rather than a high-performance jet, it is more like something that you would deliberately crash behind enemy lines in order to confuse the enemy. It might be based in theory on elegant equations and symmetry laws, but the actual implementation, with its infinite calibrations and adjustments, is a confounding mess. As discussed earlier, it is both too big to fail, and designed to fail. So how can we make it safer for those directly and indirectly affected by its activities?

Since equations are at the heart of quant finance, we'll start with the quant equivalent of the KISS principle, which is what Paul calls “the math sweet spot.” He has used this idea throughout his lectures, and sales pitches for the Certificate in Quantitative Finance.² We then give handy, actionable, and above all humble, advice to everyone else in finance, telling them how to do their jobs.

Quants: The Math Sweet Spot

You see different levels of mathematics in quant finance. Some people try to dumb the subject down. There are plenty of textbooks that kid you into thinking that there is almost no mathematics in the subject at all. But dumbing the subject down is not good. You cannot price sophisticated contracts (and yes, some of them can actually be useful) unless you have a decent mathematical toolbox, and an understanding of how to use those tools. But then there's the opposite extreme.

Some people try to make the subject as complicated as they can. It may be an academic author who, far from wanting to pass on knowledge to younger generations, instead wants to impress the professor down the corridor. He hopes that one day he will get to be the professor down the corridor who everyone is trying to impress. Or maybe it's a university seeing the lucrative quant finance bandwagon. Perhaps they don't have any faculty with knowledge of finance, certainly no practical knowledge, but they sure do have plenty of people with a deep knowledge of measure theory.

It's the latter group that is a great danger. This sort of mathematics is wonderful, if you want to do it on your own time, fine. Or become a finance professor. Or move into a field where the mathematics is hard and the models are good, such as aeronautics. But please don't bring this nonsense into an important subject like finance, where even the best models are rubbish. Every chain has its weakest link. In quantitative finance the weakest links are the models.

There is a math sweet spot, not too dumb, not too smart, where quants should focus. In this sweet spot we have basic tools of probability theory, a decent grasp of calculus, and the important tools of numerical analysis. The models are advanced enough to be able to be creative with new instruments, and robust enough not to fall over all the time. They are transparent, so the quant, the trader, and the salesperson can understand them, at least in their assumptions and use.

Because the models are necessarily far, far from perfect, one must be suspicious of any analytical technique or numerical method that is too fiddly or detailed. Being blinded by mathematical science and consequently believing in your models is all too common in quantitative finance.

To Paul, who teaches and uses the stuff, this is the reason why quant finance is interesting and challenging: not because the mathematics is complicated, it isn't, but because putting mathematics, trading and market imperfections, and human nature together and trying to model all this, knowing all the while that it is probably futile, now that's fun!

Regulators: Go Full Iceland

We've had a few laughs at the expense of the regulators in this book. But regulators are those best placed to get financial engineering and all those complex products back on the straight and narrow. We don't think it can be too hard.

There are a few basic principles that need to be adhered to, first and foremost the idea of transparency. We don't really need to say much about this, since it's already at the top of every to-do list for finance. Except to point out that transparency sounds nice, but practically no one who works with money actually wants it. Money likes to hide in the shadows.

So to do their jobs, regulators need to go on the attack. No more reacting to events. They are not police who have to wait until a crime is committed. And again, unlike the police, they can and should use profiling… some financial institutions and people have a bad reputation, and the regulators should let rip on these. There've been some bizarre individuals at the very top of the banking ladder, people who really should not be in charge of a pair of scissors let alone people's life savings. Who can forget Paul Flowers? Paul Flowers BA (Hons) FRSA FRGS. Local councilor endorsed by Labour leader Ed Miliband, Methodist minister, rising to become a non-executive director of Co-operative Bank. We are keen for people with a variety of life experiences to be appointed as non-execs, but his private life experiences, running parallel with his public life, included cocaine, methamphetamine, allegations of hiring rent boys, hiding child abuse, and a conviction for a sex act in a public toilet.³ To the newspapers he became, rather wonderfully, the Crystal Methodist. When asked by a Treasury Select Committee to outline his qualifications, earned during his sole four-year spell at a bank, he replied: “I took the exam of the Institute of Bankers. I completed part one and the best part of part two of those exams before I became a Methodist minister. I would judge that experience is out of date in terms of needs of contemporary banking.” However, he didn't resign until 2013 when it was noticed that the bank had lost £1.5 billion.

The near collapse of HBOS in 2008 was blamed on a “colossal failure of management.”⁴ So far, so standard. But one of those executives, the Chief Executive no less, was Sir James Crosby. He managed the clever trick of, for a while, simultaneously also being the Deputy Chairman of the regulator, the Financial Services Authority. Although no one has said that he acted improperly in regulating himself, other than being a colossal failure that is, it beggars belief that anyone should consider it a good idea for a banker to be at the same time a regulator. To his credit, after the initial report on HBOS was published in 2013, Mr Crosby did relinquish 30% of his pension, and his knighthood.

We could probably name a few bad apples ourselves. Fear of litigation prevents us. And that's yet another book in itself: how the legal profession protects the guilty against the innocent. So while on the subject, let's suggest decent protection for whistleblowers.

As well as hunting out bad'uns, regulators need to go on the offensive in interrogating the banks. Researchers can help out with this. Start providing regulators with ammunition, difficult questions for the banks to answer. A visit from the regulators should strike fear into the bankers, and not just be an inconvenience. Let's have more reverse stress testing. What's that, you ask? It's like a role-playing exercise for bankers, or something that lateral-thinking expert Edward de Bono might have come up with. It goes like this. The bankers have to put themselves in the position of having lost billions of dollars and then, as a show of creativity, come up with as many explanations as possible for how this could have happened. And then they have to plug the gap. Let's have some fun with this… Bank A can reverse stress test Bank B. Great amusement can be had by all. If you've seen Steve Martin in Roxanne, the scene where his character comes up with 20 imaginative insults for his large nose, then you'll know the sort of creativity that might be required. What do you mean, bankers don't have any imagination?⁵

If the regulators feel they don't have the necessary skills, or resolve, they can be sent to an intensive boot camp in Iceland, where – according to urban legend – bankers who go astray are buried in the ground up to their neck, urinated on, and left to ferment for several months (or is that an urban legend about their tasty national dish, hákarl?).

Economists: Wake Up

We've also had a few laughs at the expense of mainstream economists. Of course, it's easy to criticize, less easy to propose alternatives. But we don't need to, because there are many alternative ideas being developed all the time (we mentioned a few in Chapter 8). The problem is that these don't get the attention they deserve, because since at least the time of Adam Smith the power structure of the field has been warped by its very subject matter – money (or what should be the subject matter; as mentioned, money isn't something they study much). Adair Turner talked about “regulatory capture through the intellectual zeitgeist,” but to take it another step, the intellectual zeitgeist has been captured by finance.

We predict that in a hundred years’ time, historians will see theories such as the efficient market hypothesis as being as embarrassingly wrong as other ideas that hung around well beyond their best-by date, such as the story that planets rotate in crystalline spheres around the Earth. In the meantime, if mainstream economists want to shake their image as the Medieval theologians, or useful idiots, of the quant finance world, they need to ask how rewards from the financial sector in the form of grants, consulting gigs, and so on have shaped their field, and helped to align their core teachings so perfectly with the needs of that same sector. Or at least they should be open about their incentives. As economist Richard Denniss told the CBC: “Economists are often pretending to be impartial. They're often pretending to be putting their intellectual credibility forward in defence of something, and if they just want to be sales people then they should admit that. They should come clean with journalists, they should come clean with politicians, they should come clean with public servants, and say look I am here on behalf of someone, my opinions are irrelevant, these are the opinions I am presenting to help my client get their way.”⁶

There also needs to be a proper accounting for the role academic economists played in the crisis. As economist George DeMartino notes, the profession “failed to meet its obligations to society by failing to promote and sustain a diversity of views among its members over matters that are terribly complex and important.” Its response was instead characterized by “a herd mentality about the right way to think about financial markets and financial regulation; a dismissal of theory, evidence, and argument about the dangers associated with unregulated asset markets; and perhaps most important, a severe overconfidence among the most influential economists about the extent of economic expertise.”⁷ Above all, most economists failed to stand up when their insights were needed. Confronted with a $1.2 quadrillion derivatives bomb, all they did was play with their models. Instead of sucking up to money, or adopting the hands-off “not my problem” approach, academic economists should take a leaf from organizations such as the Union of Concerned Scientists, and speak truth to power – even if it means saying “I don't know.”⁸ Economists have an ethical responsibility, and it is not just to protect their turf and their egos.

We believe that economics is in for a period of rapid change, but it will take time for this to work through to actual practice. In the meantime, policy makers should take economists’ incentives into account when listening to their advice about things like high-frequency trading (thanks for the input, Ben!). And while they're at it, they might also ask why everyone around them appears to have worked at one time or another for Goldman Sachs.

Banks: Learn to Fail

Anyone who has lost money at the hands of identity thieves will know that getting your money back is fraught with worry and paperwork. That's supposing your bank gets beyond thinking you are the criminal. Your savings are wiped out, surely the bank just has to unwind all of the disputed activity?

In the 2010 Flash Crash, most trades at crazy prices were unwound. Wouldn't it be nice if banking could borrow some ideas from the PC world and do a simple “Restore” to a previous state? David actually got a bank to do this once, after his mother was mis-sold a mutual fund.⁹ But let's take this further. In this crazy old world, don't you sometimes wish to “Boot to Safe Mode”? Especially with no networking. I know we do. Of course this would probably only be feasible over very short time periods, but if we could reboot back to around 2005 that would be even better.

Another idea that bankers can borrow from engineering, or for that matter biology, is the idea of a controlled shutdown. When cells in the human body are damaged, they are targeted for apoptosis, a process in which the cells are taken apart and the constituents recycled for use elsewhere. Cells in a cancerous tumor have found a way to disable apoptosis, so can divide without limit. However, cells at the center of the tumor become necrotic, which means they fall apart in an uncontrolled manner. When banks fail today, their death is similarly necrotic. The collapse of Lehman Brothers, for example, left over a million derivatives transactions outstanding, and a legal mess that took years to clear up.

Regulators are increasingly demanding that banks draw up “living wills,” with instructions on what should happen in case of failure. However, as Dennis Kelleher from the lobby group Better Markets said: “The acid test is whether these are in fact credible plans. In the past they have submitted plans with all sorts of provisions and conjectures, but they didn't mean anything because they weren't credible.”¹⁰ So regulators must learn to say sorry, we're targeting you for apoptosis.

Traders: Why Does My Bonus Have a Minus Sign in Front?

Here's a word you don't hear often, malus. Unless you are a gardener, for whom it's a genus of apple trees. But if your fingers are green from counting your money rather than planting fruit trees, it's a word you ought to get familiar with. It's the opposite of a bonus, it's a penalty for performing badly. And it's something we believe should feature more prominently in banking circles.

The opportunity to become filthy rich is central to capitalism. And sometimes it can legitimately be at the expense of others, as in when you sell them something they actually want. But, just as in modern portfolio theory, that filthy rich return should be accompanied by an equally large risk. Owners of small businesses take enormous risks, especially when starting out. And when those businesses become large, the risk increases. And often they fail, and the risk is realized.

This is not what happens in banks. Nor for the CEOs of major corporations for that matter. Bankers, and quants, are massively compensated for a relatively simple job. And there is currently rarely any downside when losses are made. The worst that happens is that they lose their job. No bonuses need be returned. Even the word “compensated” carries connotations suggesting they are doing a difficult job and we should be jolly appreciative of them. No, we beg to disagree, you are doing a straightforward job, but a job that's as close to picking money off a money tree as it is possible to get. As John Cryan, co-CEO of Deutsche Bank, observed: “Many people in the sector still believe they should be paid entrepreneurial wages for turning up to work with a regular salary, a pension and probably a healthcare scheme and playing with other people's money.”¹¹ (And as someone whose job usually carries a pay package in the region of $7 million, he knows what he's talking about!)¹² According to former investment banker Sam Polk, “It's one of the most stable career paths available. Once you get to the level of making $1m a year, you rarely dip below it. Hedge fund managers who leave Goldman talk about how risky it is, but it's all upside.”¹³

But it's not just bankers. How often do you hear the multi-millionaire CEOs of major companies being described as “businessmen”? No, they're not businessmen. They just happen to have friends in the right places, they scratch each others’ backs and appoint each other to various boards. They are private-sector politicians. Just google these execs, look at their CVs, and see just how few have ever risked their own money, or ever started their own business. If you, dear reader, run your own business, perhaps it's a corner shop, or as a consultant, or plumber, then you are more of a businessman than they are. Don't let them get away with calling themselves businessmen any longer. John Ralston Saul nailed it in his book Voltaire's Bastards back in 1992: “Our business leaders hector us in the name of capitalism, when most of them are no more than corporate employees, isolated from personal risk.”¹⁴

If “compensation” in banks remains at such an unjustifiable level, then we strongly recommend the wide, and regulated, introduction of maluses as part of the pay system within the financial community. And for CEOs while we're at it.

We'd say that full public disclosure of bankers’ earnings might also help, but we're worried that would turn it into even more of a competition.

Journalists: Watch Out for Saboteurs

When investigating the financial sector, or talking to bankers, journalists are hampered by the fact that no one gives them a straight answer, and the system is incredibly confusing. For example, suppose they attend a conference on high-frequency trading. At the end of it they will probably emerge with an appreciation of the topic's complexity, and a headache, but little in the way of firm understanding, let alone guidance. They will ask themselves, at the bar afterwards, what the point of the conference was in the first place. And they will wonder why investigations seem to drag on for ever but achieve nothing.

One reason is that, unknown to them, many of the participants at such events are actually engaged in a subtle form of sabotage. Journalists therefore need to learn how to detect such activities. They can do no better than resort to the CIA's Simple Sabotage Field Manual, from 1944.¹⁵ This includes useful tips for everyone from arsonists to factory workers. Much of it reads like an excerpt from Bad Housekeeping magazine, or standard practice in the Orrell household: “Leave saws slightly twisted when you are not using them. After a while, they will break when used… In putting air into tires, see that they are kept below normal pressure, so that more than an ordinary amount of wear will result.” More relevant here is the section on General Interference with Organizations and Conferences, which perfectly describes the approach adopted by industry and government experts alike:

1. Insist on doing everything through “channels.” Never permit shortcuts to be taken in order to expedite decisions.
2. Make “speeches.” Talk as frequently as possible and at great length. Illustrate your “points” by long anecdotes and accounts of personal experiences. Never hesitate to make a few appropriate “patriotic” comments. [It's vital for the economy!]
3. When possible, refer all matters to committees, for “further study and consideration.” Attempt to make the committee as large as possible – never less than five.
4. Bring up irrelevant issues as frequently as possible.
5. Haggle over precise wordings of communications, minutes, resolutions.
6. Refer back to matters decided upon at the last meeting and attempt to reopen the question of the advisability of that decision.
7. Advocate “caution.” Be “reasonable” and urge your fellow conferees to be “reasonable” and avoid haste, which might result in embarrassments or difficulties later on.
8. Be worried about the propriety of any decision – raise the question of whether such action as is contemplated lies within the jurisdiction of the group or whether it might conflict with the policy of some higher echelon.

Above all, “Hold conferences when there is more critical work to be done.” If these all fail, saboteurs can resort to General Devices for Lowering Morale and Creating Confusion. These include “Give lengthy and incomprehensible explanations when questioned,” “Act stupid,” or in a total emergency “Cry and sob hysterically.”

Bankers are masters in this area. Consider, for example, HSBC, one of the world's largest banks, whose managers – when its lucrative sideline in money laundering came under investigation by the US Justice Department – adopted a strategy which was referred to in internal documents as “Discredit, Deny, Deflect, and Delay” (plus sob hysterically, presumably).¹⁶

Journalists can counter these techniques by copying from the same play book. A first step is to reorient their thinking “in the direction of destruction.” As an example, if an interviewee is reciting propaganda, it is “quite easy to overmodulate transmissions of talks… so that they will sound as if they were talking through a heavy cotton blanket with a mouth full of marbles.” Sorry, can you say that again – HFT is what now? No conflict of what again?

Educators: Quantity and Quality

A few years ago the Royal Statistical Society asked some UK Members of Parliament a simple question in probability: “A coin is tossed twice. What is the probability of getting two heads?” Only 53% of Conservative MPs got the answer right. But even worse, only 23% of Labour MPs knew the correct answer. But at the same time, over 70% of each party expressed confidence when dealing with numbers.

We've moaned quite a bit about the state of education in banking and quantitative finance. We'd like to see better education, specifically in more mathematical tools and techniques, to broaden out the subject from its increasingly narrow and narrow-minded specialization. A more skeptical and scientific (by which we mean the classical hypotheses and testing) attitude has to be encouraged. If something fails to work, it must be thrown out. The principle is clear. But putting this into practice is daunting. For not only are the practitioners badly educated, they, like the MPs, have an unrealistic view of their own abilities. Until a critical mass of self-awareness is reached, there will be no change.

At the same time, mathematical and technical skills are not enough! Let's broaden it even further. Quantitative finance is about numbers, but that doesn't mean it is the same as physics or engineering. The economy is not a machine, it is a living, organic system, and the numbers it produces have a complicated relationship with the underlying reality. So we want the field to be supplied with mathematicians who can also recite Shakespeare. Or at least read books. And if you think that's asking too much, just see our next recommendation.

Politicians: Create an FAA for the Financial System

The financial system has a number of parallels with another human activity that is dangerous, involves almost everyone in the developed world, and is highly regulated, as banks should be.

The Federal Aviation Administration (FAA) administers all US civil aviation matters. Their remit includes pilot certificates, air traffic control, technology, environmental effects, and safety.

In many ways, the FAA covers activities that are not dissimilar to what goes on in banks. Air transport and banking are both necessarily global; there are issues concerning safety (e.g., crashes); technology, both old and new, is important; and then there is the trustworthiness and competence of those involved.

But aviation has got its act together in a way that banks can only dream of. There is collaboration between aviation authorities around the world to the extent that an accident investigation would find many different countries assisting. Should there be an accident then there is the Black Box to help explain what happened to prevent future accidents. Should an accident reveal problems with a type of plane then those planes get grounded all around the world, pretty much immediately. And should there be a new form of terrorist attack then new security measures will immediately be implemented.

In the same way that the FAA has some control over technological matters, there should be greater control over new financial instruments. Banks should have to prove need for the product, and competence in its valuation, and crucially its hedging and risk management. That's before the contract ever gets traded.

Pilots are routinely tested, for flying abilities and also for medical and drug problems. There is also some psychological testing, which will probably increase in the future. Online you can even find information about individual pilots and their qualifications. At most, bankers are sometimes required to take basic multiple-choice exams. The contents of which are instantly forgotten once the exam has been passed. There is little requirement for maintaining and upgrading skills, so that those older bankers who have risen to the top do not have any clue what the youngsters are doing below them.

And air traffic control ensures that all planes don't try to land at the same airport at the same time. The clear parallel is that there should be control over concentration risk, so that all banks don't jump simultaneously onto the same trendy bandwagon.

Of course, the finance sector will argue that this is bad for the finance sector (as opposed to customers), because all that tedious regulation will make it shrink. But that's the idea!

The fact that these or other reforms were not implemented in the drawn-out aftermath of the last epic financial crisis might lead one to conclude that we have missed our chance for good. But if the system continues on its current path, then the next crash, and the next call for reform, will be even stronger.

I Solemnly Swear…

In late 2008, Paul – along with many other quants, and for that matter much of society – was pondering the state of the financial system. Together they had looked into the abyss. And although Paul knew that there were plenty of bad apples in banking, he also knew that the vast majority were either just confused, out of their depth, or not as smart as they thought they were. Perhaps Fama didn't know what a bubble was because he lived in one. Bankers, economists, academics, and quants each have their own bubbles. By keeping the real world out, these bubbles protect them from blowback from their actions. But they also prevent them from seeing the consequences of their actions.

Paul thought that perhaps quants ought to have some guidelines, something to – from time to time – give them a reality check. Emanuel Derman had been having exactly the same idea. So, between them, and drawing inspiration from Karl Marx and Hippocrates, at the end of 2008 Emanuel and Paul wrote the Financial Modelers’ Manifesto. It was published in Business Week. It was summarized in Scott Patterson's The Quants, and Derman's Models.Behaving.Badly. And from there it even found its way onto Jon Stewart's Daily Show. (Oprah mysteriously didn't bite.)

The full text is available online, but we include here the main part, which is the Modelers’ Hippocratic Oath. Similar principles could apply to most forms of mathematical modeling that impact society, from transport forecasting to weather prediction:

• ∼ I will remember that I didn't make the world, and it doesn't satisfy my equations.
• ∼ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
• ∼ I will never sacrifice reality for elegance without explaining why I have done so.
• ∼ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
• ∼ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

Around the same time that Emanuel and Paul were signing their manifesto, in a spooky case of synchronicity, David was sitting at his desk drinking a cup of tea. But he was also writing, in his robust yet user-friendly way, that the main thing that makes banking unusual, for such an important profession, is “its failure to develop sound ethical standards. Doctors and engineers have ethical codes; bankers have dress codes.”¹⁷ For example, the code of the US National Society of Professional Engineers, which dates to 1964, begins: “Engineers, in the fulfillment of their professional duties, shall hold paramount the safety, health, and welfare of the public.” By contrast, as economist Jason West observes, “The International Association of Financial Engineers does not consider ethics worthy of inclusion in their suggested core body of knowledge.”¹⁸ The same is true in economics.¹⁹

This omission is partly related to the fact that quants and economists do not directly and graphically experience the results of their mistakes – their actions might cause a factory to close, but its boiler doesn't blow up in their face.²⁰ But it is also related to the equivalence between models and markets, which is unique to the field: because, if finance is a quantitative science and the markets obey its laws, then it is purely objective and there is no room for individual choice or interpretation. We have outsourced ethical judgments to the invisible hand, or increasingly to algorithms – with the result that our own ability to make ethical decisions in economic matters has atrophied.

Even worse, it appears that the finance culture actually primes people to behave unethically. Experiments published in the journal Nature showed that thinking about their jobs makes bankers more likely to cheat. As the study's authors noted, “an oath, supported by ethics training, could prompt bank employees to consider the impact of their behaviour on society rather than focusing on their own short-term benefits.”²¹ In other words, it could prime them in the other direction.

So, another thing we would add to our wish list for the financial sector is a similar code for bankers. Maybe something about being careful with other people's money. A good starting point would be “First, do no harm.” Or, as Hippocrates put it in the original:

• ∼ I will utterly reject harm and mischief.

And that would rule out quite a few current practices, while leaving some room for the inevitable trade-offs involved in financial decisions. An elaborate swearing-in ceremony involving blood and maybe chickens would be a plus, but not necessary.

Of course, cynics will say that codes are just there for the sake of appearances. Which brings us to…

The Nuclear Option

As discussed in Chapter 2, quantitative finance shares part of its intellectual inheritance with the development of nuclear weapons. In July 1955, a few weeks before Einstein's death, Betrand Russell issued to a crowded press conference in London what became known as the Russell–Einstein manifesto. It laid out the options for nuclear survival in stark terms: “We appeal as human beings to human beings: Remember your humanity, and forget the rest. If you can do so, the way lies open to a new Paradise; if you cannot, there lies before you the risk of universal death.” The manifesto inspired the establishment of the Pugwash Conferences on Science and World Affairs, and the Union of Concerned Scientists. It energized the peace and anti-nuclear movements, and paved the way for the Nuclear Non-Proliferation Treaty. It marked a moment when physicists accepted a degree of ethical responsibility for their quantum creations; when they realized they were involved, so even doing nothing was a political act.

At a purely professional level, though, the manifesto appeared to be a failure, in the sense that it did nothing to counter the flood of scientists and engineers into weapons programs.²² One reason, as computer scientist Phillip Rogaway notes, is the belief in progress which characterizes such fields: “Unbridled technological optimism undermines the basic need for social responsibility.”²³ But another reason is that codes are no use unless they are enforced. Doctors have oaths, but they also have malpractice suits.

In finance, one approach would be to get more public oversight of banks, but again there is the problem of the mathematical defeat device. This won't work unless the public has access to expert witnesses who are willing to point out the flaws in models. How about making model abuse as serious an offence in finance as malpractice is in medicine?²⁴ As much as this pains us to say it, it might be time to get the lawyers involved, and not just the ones who work for banks.

But for deeper change to take place, we need not just laws but a shift in awareness – a truly cultural transformation. We need to change the story around the economy and the role of finance. This will require the participation of quants, regulators, economists, scientists, journalists, educators, policy makers, but above all the public – the ones whose jobs and businesses and futures are at stake. The anti-nuclear movement may not have prevented career-building experts from working on nuclear weapons, but it moved forward the broader debate about their development, and something similar is required today for finance. Those quant devices are not as lethal as the nuclear sort, but their abuse can harm people and societies in other ways. It may be time for a non-proliferation agreement for complex derivatives and trading strategies, and a concerted political and societal effort to roll back the power of the financial sector.

Nuclear non-proliferation ultimately depends on controlling and limiting the production of the fissile material used to make bombs. The financial version of weapons-grade plutonium is debt – it has the power to create enormous energy, or destroy countries. So, if simplicity is the aim, there is always the option of monetary reform. Make it so that banks can only lend money they actually have. An early proponent of full reserve banking, as it is known, was Nobel Laureate physicist Frederick Soddy, who was explicitly motivated by what he saw as the banking sector's threat to world peace.²⁵ Versions have also been proposed, for different reasons, by people including Irving Fisher, Milton Friedman, and Frank Knight. It has come back in favor following the crisis, with the Swiss currently planning a referendum to adopt it (though they do that kind of thing a lot), and Iceland also considering it (!).²⁶ It has its disadvantages – not least the total lack of support from banks – but would certainly make the system easier to control.

So, now that we have set the financial world straight, we'll end with some thoughts on what this all means for the average investor (and you thought we'd never get round to it!).